Comment

Is India heading towards a challenging couple of quarters?
The consensus is a big YES.

So much so, the country’s GDP growth can even slip under 7% if the headwinds intensify.

The situation can rapidly deteriorate if global economic conditions, especially capital market conditions, worsen anew due to the lingering European crisis.

While no credible solution is sight to “unscramble the monetary union omelette” in Europe, on its part, India has been losing momentum rapidly with investment activity stalling and consumption slowing following policy uncertainty and tight monetary conditions.

Second-quarter GDP growth has already slipped to 6.9% year on year and October industrial production registered a de-growth of 5%, indicating that real GDP growth may slip closer to 7%, which would be below-trend growth for India.

Adding to the uncertainty is the sharp depreciation of the rupee, which has lost about 18% in value against the US dollar in since September.

This has compounded the woes of importers and corporates with foreign currency loans. A weaker rupee also threatens to stoke inflationary pressures from imported commodities, particularly oil.

The overall picture, thus, doesn’t inspire confidence — at least in the short term, while the long-term fundamentals of India are well-established.

How the events around the euro zone unfold is crucial going forward as any pressure on the global banks will enlarge the deleveraging wave. That would add to the stress on the Indian economy, both from trade and capital flow routes.

Noting the deterioration in local growth momentum and intensifying troubles in the euro zone, the Reserve Bank of India (RBI) has decided to pause its rate hike cycle.

Mint Road also signalled last Friday that it may now reverse the tight monetary policy course and the next policy move would more likely be a cut in the repo rate.

The language of the latest policy review suggests a more “balanced” approach from the RBI going ahead, with greater recognition to growth concerns in the backdrop of euro zone sovereign crisis.

The RBI sounded more sanguine on the price front, stating inflationary pressures are likely to abate in coming months despite high crude oil prices and rupee depreciation.

Even non-food manufacturing inflation can ease, as pricing power of the manufacturing sector is getting squeezed as consumption is slowing down, it averred.

However, cautioned that inflation risks remain high with a significantly weaker rupee and elevated crude oil prices and inflation could rise on account of both demand and supply factors.

In terms of actual reversal of policy rates, the RBI may not be in a position cut rates before the first quarter of the next fiscal year.

Headline inflation, though likely to ease along the RBI trajectory by March, could still remain above 7% in the first quarter or even the first half of the next fiscal year, the so-called ‘new normal’ for India.
Core inflation, which still is at 7.9%, would have to ease to 6-6.25% for the RBI to consider a rate cut.

A cash reserve ratio cut is likely to precede an interest-rate cut and may only come towards early March.

A break-up or conflagration in Europe could force the RBI to cut rates earlier than anticipated, especially if it spawns another crisis in the global financial system.

On its part, the rupee would continue to trade with depreciation bias against the dollar because growing risk aversion globally would strengthen the greenback.

That, combined with the fact that Brent crude holds well above $100 per barrel and local stock market conditions look weak, the tendency of the rupee would be to weaken.

The worst may more or less be behind the currency, as the RBI is now showing greater resolve in stanching its depreciation through direct intervention and control measures.

A dollar liquidity squeeze in the global financial system or a sharp pick-up in capital outflows can upend all that, however.

For now, the RBI has bought time for the government to resume its policy action. But the policy paralysis at the Centre looks set to persist for some time to come, which threatens to degenerate India’s fiscal position.

There’s little to feel inspired about.

The author is senior economist, Royal Bank of Scotland NV. Views are personal. gaurav.kapur@rbs.com